Mortgage Relief Act and definition of 'Principle' Residence

Mortgage Forgiveness Debt Relief Act. Read the bill here: http://www.govtrack.us...

Section 2, part 5:
(5) PRINCIPAL RESIDENCE- For purposes of this subsection, the term `principal residence’ has the same meaning as when used in section 121.’.

Section 121 of the IRS code http://www.law.cornell... deals with capital gains tax exclusion on principal residence if a person lives in the home for the past 2 (aggregated) of 5 years.

As clearly outlined by the Mortgage Forgiveness Debt Relief Act, the IRS defines principal residence according to Section 121 of the IRS code, which states that it had to have been the person's principal residence for 2 of the past 5 years before the date of the sale (or foreclosure with regards to the Mortgage Debt Relief).

As a clarification, the IRS modified Section 121 in 2008 so that if you had purchased a property as a non-qualified principal residence use (rental property, vacation home, second home), and then converted it to a qualified principal residence by moving back in, you do NOT get to claim the full capital gains exclusion. You can only claim the portion of the time it was a qualified principal residence versus non-qualified principal use.

On the flip side, if you had purchased a home as a qualified principal residence, and then converted it to a non-qualified principal residence use, as long as you qualify for the aggregated 2 of 5 year condition, you can still exclude the full capital gains exclusion.

 

So am I interpreting the relief act and what constitutes a principle residence correctly?  If I had bought a condo and lived in it for a little over 2 years, moved away because of a job, and rented it out for less than 3 years, and then it was foreclosed on, can I still claim it using form 982 under the Mortgage Debt Relief Act as a principal residence, even if I was living in another home at that time?  Again, the bill clearly defines principal residence as having the same meaning as in Section 121 of the IRS code.  Though Section 121 doesn't clearly spell it out, the code implies that principal residence qualifies for capital gains exclusion if lived in for 2 of 5 years from date of sale.

Section 121 of the IRS code specifically states you can't claim 2 homes as principle residences for capital gains purposes unless one claim occurs 2 years after a previous principal residence sale claim.

solara:

So am I interpreting the relief act and what constitutes a principle residence correctly?

No, you are not. By way of background, IRC § 108(a)(1)(E) states that "qualified principal residence indebtedness which is discharged before January 1, 2013" is not included in the taxpayer's income. Instead, the basis of the home is reduced by the amount of the debt discharged (but not below zero). The effect of this provision is to defer the income until the home is sold, and to convert what would have been ordinary income to capital gain income, which is taxed at lower rates. This provision was added in 2007 during the Bush Administration, and the Congress stated its reason for the bill as follows: "The Committee believes that where taxpayers restructure their acquisition debt on a principal residence or lose their principal residence in a foreclosure, that it is inappropriate to treat discharges of acquisition indebtedness as income."

For the purpose of the exclusion in § 108(a)(1)(E), § 108(h)(5) states that "the term 'principal residence' has the same meaning as when used in section 121." IRC § 121 is the provision that excludes up to $250,000 of gain ($500,000 in the case of married taxpayers filing a joint return) on the sale of a home if the taxpayer both owned the home and lived in it as his principal residence for at least two of the 5 years immediately preceding the date of the sale. There some other limitations on this exclusion that are not relevant here. What you have done is equate qualifying for the exclusion with the definition of "principal residence." But that's not correct. Principal residence tells you what you must have owned and lived in for 2 of the last 5 years. It is thus just a part of what it takes to qualify for section 121. What Congress was saying in § 108(h)(5) is that it wants "principal residence" to mean the same thing for that provision that it does for § 121, not that you must qualify for § 121.

So, the issue is, what does "principal residence" mean under § 121? The statute does not actually define the term. What Congress was doing here adopting the definition the IRS had issued in regulations for § 121. Specifically, Treas. Reg. § 1.121-1(b) states:

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(b) Residence--(1) In general. Whether property is used by the taxpayer as the taxpayer's residence depends upon all the facts and circumstances. A property used by the taxpayer as the taxpayer's residence may include a houseboat, a house trailer, or the house or apartment that the taxpayer is entitled to occupy as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in section 216(b)(1) and (2)). Property used by the taxpayer as the taxpayer's residence does not include personal property that is not a fixture under local law.

(2) Principal residence. In the case of a taxpayer using more than one property as a residence, whether property is used by the taxpayer as the taxpayer's principal residence depends upon all the facts and circumstances. If a taxpayer alternates between 2 properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. In addition to the taxpayer's use of the property, relevant factors in determining a taxpayer's principal residence, include, but are not limited to--

(i) The taxpayer's place of employment;

(ii) The principal place of abode of the taxpayer's family members;

(iii) The address listed on the taxpayer's federal and state tax returns, driver's license, automobile registration, and voter registration card;

(iv) The taxpayer's mailing address for bills and correspondence;

(v) The location of the taxpayer's banks; and

(vi) The location of religious organizations and recreational clubs with which the taxpayer is affiliated.

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That is the definition of "prinicipal residence." The other parts of § 121 about owning the home andl living in it for 2 out of the last 5 years are not relevant.

Under your facts, the condo was not your principal residence when it was foreclosed upon and hadn't been for nearly 3 years. As a result, it would not qualify for the relief of § 108(a)(1)(E). The bill was meant to help homeowners when restructuring debt on their current home or when they lose that home home to foreclosure. You didn't lose your home, you lost an investment property. However, you might still find relief in the insolvency exception of § 108(a)(1)(B). This assumes that the leftover debt after the foreclosure was actually discharged (i.e. forgiven/canceled). If the debt hasn't been discharged yet, there isn't any income yet to worry about.

 

 

Laymans take:

I suspect taxagent is dead on target as always--and you do NOT have a good fact pattern to argue otherwise as clearly you moved away due to job.

Now a strict read of taxagents analysis would suggest that any  homeowner who attempts to  fight off foreclosure and doom by desparate renting out of home stands to lose any benefit of the Mortgage Relief Act  by the mere step of short term loss of property not being individuals principal residence  at the instant of debt forgivness  --whether or not Congress intended to strp benefits of the Act from those who tried to avoid down fall or to limit application to a precise set of conditions is a bit hard to divine w/o reading all the congressional record.....but you are not presenting a good fact pattern to be worth any such adventure and I'm quite confident that taxagent has it right--you do not fit the rule!

Had youmoved back into residence as your principal residence it would be a different fact pattern?

Note the exception  as to nonrecognization of gain due to being insolvent--if it applies--its a better tax answer if it applies! Its forgiven not just postponed!

Note be sure you figured required depreciation into your basis computation....

 

Drew:

Now a strict read of taxagents analysis would suggest that any homeowner who attempts to fight off foreclosure and doom by desparate renting out of home stands to lose any benefit of the Mortgage Relief Act by the mere step of short term loss of property not being individuals principal residence at the instant of debt forgivness

Under the right set of facts, I'd be willing to argue the moving out and renting it for a very short period of time before foreclosure would not disqualify the taxpayer from relief. That's because the regulation looks to which home was your main home for any given time, and a temporary absence from a home won't disqualify it as your principal residence. But the facts would have to suggest, I think, that the taxpayer's conversion of the property to a rental was meant only for a short time. Thus, a longer-term lease of, say, six months or a year would a real problem. But perhaps a month-to-month rental that lasted just a few months before the foreclosure went through would still fly. No way to know as that has not been litigated yet. But where the had been converted to a rental for 2-3 years prior to the foreclosure, as in the facts presented here, there isn't going to be an argument that it was the taxpayer's "principal residence" to qualify for the debt discharge relief.

Drew:

Had youmoved back into residence as your principal residence it would be a different fact pattern?

Again, under the right set of facts, that might work, and would be a stronger case as it would fit more neatly with the statutory language. Here, if I were advising the taxpayer, I'd ideally want them to give up the other residence so that they have only one residence at the time of foreclosure, to bolster the argument that it was the principal residence. Short of that, they'd need to take steps to make it clear that moving back to that home was not merely temporary to gain the benefits of the provision but rather a bona fide move to make it their principal residence, i.e. changing driver's license address, address with the post office, changing the kid's schools, and all the other things you do when you permanently change residences. This, too, has not yet been litigated so what might work here is not really known. But, of course, this is not the poster's facts.

Drew:

Note the exception as to nonrecognization of gain due to being insolvent--if it applies--its a better tax answer if it applies! Its forgiven not just postponed!

That's not accurate. If you use the insolvency exception, you must make other tax adjustments if possible, like reducing carry-over losses or reducing basis in assets that you have, to compensate. Thus, it could result in the same kind of deferral that the mortgage forgiveness provision does. The advantage of the mortgage forgiveness provision is that it does not require that you be insolvent to get the benefit and it only requires the one adjustment of basis to the home, not the other adjustments that the insolvency exception does. Thus, in general you want to be in the home mortgage forgiveness provision, not the insolvency exception. Note that where both provisions would apply, the statute has an ordering rule that says the mortgage forgiveness provision takes priority.

Okay, thanks very much for the detailed responses.  I was hoping to have an easy way to do my taxes when the 1099-C comes even though technically I should not be getting a 1099-C.

California purchase-money, owner-occupied loans are considered non-recourse by CA civil code, and are determined at the time of loan creation (nevere refinanced, no second mortgage).  So owner-occupied for 2 years, rented for 3 years, then foreclosed, the loan still remains non-recourse and would not incur COD income.  But banks will send 1099-C's out routinely, so I'll have to claim the income tax exclusion in a more difficult way - by printing out the return and making a note to the IRS.

Btw, I've asked on a few forums, and I think here too, and that seemed to be the consensus (that CA purchase-money, owner-occupied loans, never refinanced remain non-recourse even if home was subsequently rented out before foreclosure?).  The responses I've gotten on this thread are first-class and very well-written.  Hoping someone can correct me if I'm wrong with regards to that assumption?  Thanks!

Thatrs a differenrt can of worms and beyond me--in a sense there is no forgivness of nonrecourse debt.

solara:

Btw, I've asked on a few forums, and I think here too, and that seemed to be the consensus (that CA purchase-money, owner-occupied loans, never refinanced remain non-recourse even if home was subsequently rented out before foreclosure?). The responses I've gotten on this thread are first-class and very well-written. Hoping someone can correct me if I'm wrong with regards to that assumption? Thanks!

That seems to be the case—see the brief discussion of it from the CA FTB website. However, I cannot say for certain as I do not practice in that state and have not studied the mortgages laws of CA in detail. You may want to see a CA tax attorney to verify that your loan would indeed be treated as nonrecourse. If it is nonrecourse, that will give you the best tax outcome as to any excess on the loan that was not paid by the foreclosure because in that case there is no debt discharge. Yes, you may need to attach an explanation of that to the return should you get a Form 1099-C (and the lender should not send one in that situation) and cannot get the lender to correct the 1099-C before the return is due. In my experience, that is not as bad as you seem to be thinking it will be.

My wife and I retired in 2005 and bought a condo in Florida as our retirement home and principal residence. We voted there, received our mail there, cars were registered there, were homesteaded there, etc. We were residents for almost three years, moving back to our home in PA in 2008, due to my wife's health. We are in process of a short sale for the Florida condo. We don't live there now but did for more than two years of the past five. Will our forgiven debt be taxed or not? If not, would moving back now, before the short sale closing, help?

There really don't seem to be any clear answers on this. Any help will be appreciated.

 

There are two federal income tax issues that come up with a short sale of real estate. The first is whether there is any taxable gain from the sale of the property and the second is whether there is any taxable income from the discharge of debt on the mortgage loan.

Dennis F.:

. We were residents for almost three years, moving back to our home in PA in 2008, due to my wife's health.

The fact that you lived in the home for almost 3 years out of the last five is relevant for the first issue of taxable gain on the sale. The basic rule is that when you sell property, you are taxed on the difference between the sale price (after expenses of sale are deducted) less your adjusted basis in the home. For example, suppose Amy bought vacant lot in 2005 for $100,000 and sold it in 2010 for $150,000. Her basis is the $100,000 she paid for it. Thus, her gain here is $150,000 sale proceeds less $100,00 basis = $50,000. That's the amount she'd include in income as a long-term capital gain and she'd pay federal income tax on that at a rate of up to 15%.

But there is a special rule for the sale of your personal residence. If you owned the property and lived in it as your principal residence for at least 3 of the 5 years immediately preceding the date of the sale, you may exclude from income your gain up to $250,000 ($500,000 if married and filing a joint return). So, if in the above example, the property had been Amy's principal residence for 3 of the 5 years before she sold it, she'd be able to exclude her entire $50,000 of gain since that's less than the $250,000 limit of gain the law allows her to exclude.

If Amy had to move from the home before living in it for the necessary three years, she can still exclude some gain from income if her reason for moving was due to a job change, health problems, or certain other unforeseen circumstances. For example, suppse she had to move after living in the home for 27 months because she needed to live in a drier climate as a result of a new health problem she had. Because she didn't meet the 3 year test, the maximum gain she can exclude from income is reduced by the following formula: number of months she lived in the home divided by 36 months that she was required to live in the home for the full exclusion times the maximum exclusion amount ($250,000 or $500,000, as applicable). So, for Amy, that would be 30/36 x $250,000 = $187,500 maximum gain she can exclude from income. Since her gain of $50,000 is still less than the maximum of $187,500 she can exclude, she still has no tax on the gain from the sale of her home.

For more information on this, see IRS publication 523.

The second issue is whether you will have any gain from a discharge (cancellation/forgiveness) of debt. The general rule here is that you include in ordinary income the amount of any discharged debt. There are two exceptions that which may apply to you. First, the law provides that debt discharges on the loan you used to buy a principal residence are not included in your income. Home equity loans, etc., that you get after you buy the home do not qualify for this relief. In addition, the debt discharge must occur before 1/1/2013. Second, some or all the debt that is discharged may be excluded from income if you were insolvent (i.e. your total debt exceeded the fair market value of all your assets) at the time of the debt discharge. I've explained this rule in more detail in earlier posts on this site. Under both exceptions, other tax adjustments may be needed to compensate for the fact that you are excluding some or all of the debt discharge from income. If the the lender cancels the remaining debt you owe on the condo after the short sale, then you'll have a debt discharge and in that case you'll probably want to see a tax professional (enrolled agent, CPA, or tax attorney) for advice to make sure you handle everything correctly. You might not end up with any income tax out of this, but you want to be sure you get it right and report it accurately.

Thank you, Taxagent, for your excellent and thorough response! In my case there will be no capital gain to worry about since we paid $315K for the condo in 2005, did about $10K in capital improvements, and our current mortgage balance is about $250K. After seven months on the market, we just received our first offer -- $80K. The mortgage balance is about $250K (OUCH!).

Our concern then, is whether we would be liable for the quite substantial income tax on the anticipated forgiven debt of about $170K. It appears we have an argument for exemption from this tax, but since we have not been using the condo as our principal residence for the past 2 1/2 years, there seems to be a question as to whether the condo can/would be considered our principal residence for tax relief purposes; and secondly, whether moving back to the condo now, for 2 - 3 months prior to the short sale closing, would make any difference in eligibility for the tax relief. I'm still unclear on this.

A related question has to do with insolvency. Is this determined by net worth prior to or immediately after a short sale and debt forgiveness? In my case, the liability of the condo mortgage tips the balance to insolvency, but after the mortgage debt is forgiven, the balance is to greater assets and solvency. Would insolvency for tax relief apply in this case?

If insolvency would apply in this situation, might it be more advantageous to go the insolvency route vs. the qualified principal residence route, particularly since insovency seems much more clear. Further, if I went the principal residence route, and that was later denied after tax returns are reviewed the following year, or later, could I then apply the insolvency provision as a backup, retroactively?

I accept your recommendation to seek professional counsel on these issues, but I appreciate your insight; I have a significant problem here. Thanks again.

If a person used the property as a qualified principal residence for some, but not all, of the required minimum time prior to the closing of a short sale, would a portion of the forgiven debt be considered not taxable income under the Mortgage Relief Act, in proportion to the percent of time the property was used as a prinipal residence? Or is it all or nothing -- a minimum of 24 months for any relief under the act?

For example, the bank forgives $100,000 mortgage balance in a short sale. The mortgagee used the property as a principal residence for 18 months (of the required 24 months) in the 5 years immediately prior to the sale. Would only 25% of the forgiven debt be considered taxable income, since 18 months would represent 75% of the required 24 months for a qualified principal residence exemption, or would all of the $100,000 be taxable?

We are in a situation similar to this where, depending upon interpretation, we could be considered to be short of the 24 months by only a few weeks. As I understand it, this proportionality applies in capital gains exclusion situations, as addressed in the above reply, but I'm not clear on how it might apply in this situation. Any and all help and insight will be appreciated!

Our move was due to health issues, and we have only the first mortgage, used to buy the property, so it appears we are otherwise eligible for tax relief on any forgiven debt. It seems either 96% +/- of the forgiven debt would not be taxable, or it ALL would be, depending on whether use time of less than 24 months would be applied proportionately. The debt forgiven would be about $170,000 so whether 100% or 4% of this is taxable makes a HUGE difference.

Dennis F.:

If a person used the property as a qualified principal residence for some, but not all, of the required minimum time prior to the closing of a short sale, would a portion of the forgiven debt be considered not taxable income under the Mortgage Relief Act, in proportion to the percent of time the property was used as a prinipal residence? Or is it all or nothing -- a minimum of 24 months for any relief under the act?

The two years out of the last five is the test for determining whether any GAIN on the sale is excluded from income. It does not apply for determining whether the discharge of the mortgage debt deficiency is excluded from income.

Rather, the requirement is that the debt must be "qualified principal residence indebtnedness" as defined in IRC § 108(h)(2). Described in plain English, it must the loan you borrowed to buy a principal residence. There is a cap on the amount of the loan that can qualify (which you won't have to worry about unless it was over $500,000), and the reason for the discharge must be due to the decline in value of the principal residence. Thus, the fact that you didn't live in the home for a full two years will not itself affect whether the discharged debt on the mortgage in the shore sale can be excluded from income under the rule for discharges of qualifed principal residence indebtnedness.

But as I said, the two years out of five years does affect the extent to which gain may be excluded in income. This is important to you because IRC § 108(h)(1) requires that any discharged debt excluded under this rule reduces your basis in the principal residence. Here, if you fall short of the 2 years, you cannot excluded any of the gain unless you had to move due to certain events that were unforeseen when you bought the property. Moving for health reasons can be an event that qualifies. If you have a qualifying event, then you can prorate the maximum gain exclusion. For example, the maximum gain exlusion if you met the two years is $500,000 if you are married filing a joint return. Lets say you lived in it for 20 months and then had to move due to unforeseen health issues that came up after you bought the home. The maximum gain that you could exlude in that case is 20/24 x $500,000=$416,666.67. If your gain (after taking into account the reduction for the discharged debt) was below that, none of it would be included in income and thus would not be taxed.

Taxagent,

Wow! What great information! From all indications, it certainly appears we would not have any taxable income resulting from the pending short sale. We paid $315K for the property and moved there in 2005, and lived there until January 2008 when we moved out due to my wife's health issues. Our loan/fees balance is about $250K and, after being listed for seven months, we finally have an offer -- for $80K. Even with debt forgiveness of $170K we would still have no gain on which to be taxed, if I'm reading all of this correctly ($80K + $170K - $315K = -$65K). And the 2 in 5 rule becomes moot.

Thank you for your analysis and quick response; I appreciate it very much.

Dennis F.:

We paid $315K for the property and moved there in 2005, and lived there until January 2008 when we moved out due to my wife's health issues. Our loan/fees balance is about $250K and, after being listed for seven months, we finally have an offer -- for $80K. Even with debt forgiveness of $170K we would still have no gain on which to be taxed, if I'm reading all of this correctly ($80K + $170K - $315K = -$65K). And the 2 in 5 rule becomes moot.

It's unfortunate that your home's value declined so much; at least with the short sale and discharge of debt, your end loss out of this isn't as bad as it could be. Your initial basis in the home was $315,000. If the debt discharge is $170,000, that reduces the basis to $145,000. Since the sales price is just $80,000, you have a loss on the sale and thus no taxable gain to worry about. The loss on a personal residence is, of course, not deductible. So the bottom line ends up that you'll have some reporting to do on the return, but the net tax effect here is zero—no impact on the amount of tax you pay.

"Rather, the requirement is that the debt must be "qualified principal residence indebtnedness" as defined in IRC § 108(h)(2). Described in plain English, it must the loan you borrowed to buy a principal residence."

Ok...after reading the above replies I am still a little confused if this exclusion(qualified principal residence indebtedness) will apply or not apply to my situation.

I purchased my principle residence in Nov 2006.  I moved to pursue a new career in June 2009.  I rented my home in Aug 2009 which is not creating any profit.  My lender offered me a loan modification in June 2010 which I accepted.  The lender forgave $43000 of my $182000 mortgage.

Please explain how my situation applies.

Thanks